I believe in getting a sense of the direction of the stock market using trend analysis. I use trend analysis to determine if I should be in the stock market or not, specifically the 12 month moving average against the S&P 500 index.
However, one of the problems with trend analysis is it sometimes give your false signals. The price of the index will break the trend. Then the index will snap back with a vengeance. In fact, when it does you can lose 5% of your initial price position. This is a risk with all systems. No system is full proof or air tight and it never will be. The purpose of this post is to put some subjectivity into trend analysis, by viewing it in conjunction with the economy as a whole, or more precisely the tangible evidence of economic activity, that is with the other economic indicators.
Does this break the spirit the whole point of using something like moving averages? Maybe, but I think flash traders and computerized trading sometimes adds an extra level of volatility and false signals, and what can I say I am not a purist.
What I do (lately) is try to look at the tend against the economy as a whole as manifest by the other economic indicators. The Conference board, a non government agency has for the last fifty years had a good track record with predicting economic business cycles with it simple set of indicators they feel are relevant. This is not insider information, but I am surprised at how few investors really look at the data and understand how important it is.
Note, these are not the only indicators out there. There are many others, but these are a start, as the major and minor indicators are discussed.
Why look at these indicators? Given the fact that the stock market is a pretty good leading indicator of the economy as a whole. Rarely do bulls precede recessions and conversely rarely do bears precede strong recoveries. The lag time is about six months. That is if the economy is going to be down in six months time, then the stock market will start to falter. If you could see the future of GDP in six months you will have a pretty good ideas of where the stock market will go. Therefore, if you are unsure of what is going on, pour over the economic data yourself and make your own call about the health of the economy. I am a believer there are not experts in life and many great economist mis-predict the direction of the economy. Therefore, believe in yourself and your ability to see patterns in this data.
A trend is three
I like simple rules so here is one. What constitutes a trend when you are looking at broad economic indicators? A trend is three. That means if you have three months of negative GDP (a current indicator), that means the economy is probably trending to a recession. One or two months is iffy, but three, then we are most likely going down. Also for a trend to reverse, it would have to be three months of growth.
- Therefore, if you feel GDP, which is a current indicator, not a leading or lagging indicator is going down in six months time, and the market index has broken the trend line, this is the time to start dollar cost averaging your positions out.
- However, if you feel the economy still has some life and even growth in it, despite the fact the index price has broken down below the moving average, then I personally would not sell. I would wait a while and see what is happening.
How do you know where the economy as a whole is going?
Beside the noise in the media, look yourself at the aggregate of the ten leading economics indicators. To look at the conference boards ten business cycle indicators go here -> Leading economic indicators. Then go to the USA and you can analysis the data yourself instead of hearing it recycled from the press. If the data on that page is too convoluted, then sure read up on the summary of this data via other people, but first take a stab at it yourself.
Perhaps this post has raised more questions then it has answered. However, when I was in school I took a course just in economic indicators. At the time I was amazed by the power and simplicity of this data. I was loading up on other courses in mathematical economics as I was considering a PhD in economics. However, this little elective course on leading and lagging indicators impressed me. I used it and of course like all systems after it was working, for me for a while, I forgot about it, and stopped using it or only causally listening on other people’s analysis of the data.